Research or Experimental Expenditures

DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[TD 8562]

RIN 1545-AM92

Research or Experimental Expenditures

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Final regulations.

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SUMMARY: This document contains amendments to the Income Tax

Regulations clarifying the definition of research or experimental

expenditures and providing guidance regarding the reasonableness

requirement of section 174(e), added to the Internal Revenue Code by

the Revenue Reconciliation Act of 1989. These amendments affect

taxpayers conducting research or experimentation in connection with a

trade or business.

EFFECTIVE DATE: October 3, 1994.

FOR FURTHER INFORMATION CONTACT: Lisa J. Shuman, (202) 622-3120 (not a

toll-free number).

SUPPLEMENTARY INFORMATION:

Background

Section 174 of the Internal Revenue Code (Code) provides two

alternative methods that taxpayers may use to account for research or

experimental expenditures. A taxpayer may either deduct the

expenditures in the year in which they are paid or incurred, or treat

the expenditures as deferred expenses, amortizable over a period of at

least 60 months. In 1957, the IRS adopted Sec. 1.174-2(a)(1), which

defines the term research or experimental expenditures as expenditures

which represent research and development costs in the experimental or

laboratory sense (22 FR 7901 (October 4, 1957)).

In 1993, the IRS proposed amendments to Sec. 1.174-2(a)(1) to

clarify the definition of research or experimental expenditures (58 FR

15819 (March 24, 1993)). The amendments also provide guidance regarding

section 174(e), which was added to the Code by the Revenue

Reconciliation Act of 1989. Section 174(e) provides that the accounting

rules of section 174 apply to a research or experimental expenditure

only to the extent that the amount of the expenditure is reasonable

under the circumstances.

The IRS received comments on the proposed amendments both in

writing and at a public hearing on June 18, 1993. This Treasury

decision adopts the proposed amendments with several revisions in

response to public comments.

Explanation of Provisions

A. Clarification of Uncertainty Test

As noted above, the 1957 regulations define research or

experimental expenditures as expenditures which represent research and

development costs in the experimental or laboratory sense. The proposed

amendments provide that expenditures represent research and development

costs in the experimental or laboratory sense if they are for

activities intended to discover information that would eliminate

uncertainty concerning the development or improvement of a product.

Under the proposed amendments, the requisite uncertainty exists if the

information reasonably available to the taxpayer does not establish the

capability or method for developing or improving the product.

Several commentators expressed concern that the uncertainty test

provided in the proposed amendments could be construed to limit unduly

the definition of research or experimental expenditures. In particular,

the commentators argued that the test could exclude expenditures

incurred to determine the appropriate design of a product if the

taxpayer knows at the outset that the procedure will be successful. In

such a case, the taxpayer is not uncertain as to either its capability

to develop the product or the method by which it will develop the

product.

The Treasury Department and the IRS agree that a taxpayer's

knowledge that a product development project will be successful does

not preclude the process of determining the appropriate design of the

product from qualifying as research. The Treasury Department and the

IRS also agree that the language of the uncertainty test provided in

the proposed amendments could be construed to reach a result contrary

to that intended. The final amendments thus clarify the uncertainty

test. Under the final amendments, the requisite uncertainty exists if

the information available to the taxpayer does not establish either (i)

The capability or method for developing or improving the product, or

(ii) the appropriate design of the product.

The uncertainty test, as clarified in the final amendments,

reflects the dual purposes of section 174. Congress enacted section 174

not only to encourage research, but also to avoid the difficult tax

accounting questions that would arise regarding research expenditures

in the absence of special tax accounting rules. See H. Rep. 1337, 83d

Cong., 2d Sess. (1954), reprinted in 1954 U.S.C.C.A.N. 4017, 4053.

These difficult tax accounting questions would not be limited to cases

in which the success of a product development project is in doubt. If a

given line of inquiry proves to be unfruitful, questions could arise

regarding whether the costs involved could be deducted, or whether the

knowledge gained from the inquiry might contribute sufficiently to the

ultimate design of the product that the costs must be capitalized. In

short, the tax accounting questions that section 174 was meant to

resolve can arise whenever the taxpayer is uncertain as to the

capability or method for developing or improving the product, or the

appropriate design of the product.

The proposed amendments apply the uncertainty test with reference

to ``the information reasonably available to the taxpayer.'' The

Treasury Department and the IRS agree with the commentators that the

meaning of the phrase reasonably available is unclear. Further, the

phrase could be read to impose an unintended restriction on the

definition of research or experimental expenditures. Information could

be considered to be reasonably available to a taxpayer if the taxpayer

can obtain the information through procedures that, while not

particularly involved, are nonetheless in the nature of research

activities. To avoid the ambiguities resulting from the term

reasonably, the final amendments provide for the application of the

uncertainty test with reference to the information actually available

to the taxpayer. The removal of the term reasonably is not intended to

expand the information considered to be available to the taxpayer.

B. Validation Testing

The 1957 regulations exclude from the definition of research the

ordinary testing or inspection of materials or products for quality

control. Several commentators on the proposed amendments asked for

clarification that research includes validation testing to ensure that

a product design meets its intended objectives. In response to these

comments, the final amendments clarify that the existing exclusion for

quality control testing does not apply to testing to determine if the

design of a product is appropriate.

C. Effective Date

The final amendments retain the effective date of the proposed

amendments, and thus apply to taxable years beginning after October 3,

1994. Some commentators requested that the proposed amendments apply to

all open taxable years. Because the amendments merely clarify the

existing definition of research or experimental expenditures,

retroactive application of the amendments is unnecessary. Return

positions consistent with the amendments will be consistent with the

existing regulations and will be recognized as such by the IRS.

Special Analyses

It has been determined that this Treasury decision is not a

significant regulatory action as defined in EO 12866. Therefore, a

regulatory assessment is not required. It has also been determined that

section 553(b) of the Administrative Procedure Act (5 U.S.C. chapter 5)

and the Regulatory Flexibility Act (5 U.S.C. chapter 6) do not apply to

these regulations, and, therefore, a Regulatory Flexibility Analysis is

not required. Pursuant to section 7805(f) of the Internal Revenue Code,

the notice of proposed rulemaking preceding these regulations was

submitted to the Small Business Administration for comment on their

impact on small business.

Drafting Information

The principal author of these regulations is Lisa J. Shuman of the

Office of Assistant Chief Counsel (Passthroughs and Special

Industries), IRS. However, other personnel from the IRS and Treasury

Department participated in their development.

List of Subjects in 26 CFR Part 1

Income taxes, Reporting and recordkeeping requirements.

Amendments to the Regulations

Accordingly, 26 CFR part 1 is amended as follows:

PART 1--INCOME TAXES

Paragraph 1. The authority citation for part 1 continues to read in

part as follows:

Authority: 26 U.S.C. 7805 * * *

Par. 2. Section 1.174-2 is amended as follows:

1. Paragraph (a)(1) is revised.

2. Paragraphs (a) (2) and (3) are redesignated as paragraphs (a)

(8) and (9), respectively.

3. New paragraphs (a) (2) through (7) are added.

4. Paragraph (c) is amended by removing the reference ``sections

615'' and adding ``sections 617'' in its place.

5. The additions and revisions read as follows:

Sec. 1.174-2 Definition of research and experimental expenditures.

(a) In general. (1) The term research or experimental expenditures,

as used in section 174, means expenditures incurred in connection with

the taxpayer's trade or business which represent research and

development costs in the experimental or laboratory sense. The term

generally includes all such costs incident to the development or

improvement of a product. The term includes the costs of obtaining a

patent, such as attorneys' fees expended in making and perfecting a

patent application. Expenditures represent research and development

costs in the experimental or laboratory sense if they are for

activities intended to discover information that would eliminate

uncertainty concerning the development or improvement of a product.

Uncertainty exists if the information available to the taxpayer does

not establish the capability or method for developing or improving the

product or the appropriate design of the product. Whether expenditures

qualify as research or experimental expenditures depends on the nature

of the activity to which the expenditures relate, not the nature of the

product or improvement being developed or the level of technological

advancement the product or improvement represents.

(2) For purposes of this section, the term product includes any

pilot model, process, formula, invention, technique, patent, or similar

property, and includes products to be used by the taxpayer in its trade

or business as well as products to be held for sale, lease, or license.

(3) The term research or experimental expenditures does not include

expenditures for--

(i) The ordinary testing or inspection of materials or products for

quality control (quality control testing);

(ii) Efficiency surveys;

(iii) Management studies;

(iv) Consumer surveys;

(v) Advertising or promotions;

(vi) The acquisition of another's patent, model, production or

process; or

(vii) Research in connection with literary, historical, or similar

projects.

(4) For purposes of paragraph (a)(3)(i) of this section, testing or

inspection to determine whether particular units of materials or

products conform to specified parameters is quality control testing.

However, quality control testing does not include testing to determine

if the design of the product is appropriate.

(5) See section 263A and the regulations thereunder for cost

capitalization rules which apply to expenditures paid or incurred for

research in connection with literary, historical, or similar projects

involving the production of property, including the production of

films, sound recordings, video tapes, books, or similar properties.

(6) Section 174 applies to a research or experimental expenditure

only to the extent that the amount of the expenditure is reasonable

under the circumstances. In general, the amount of an expenditure for

research or experimental activities is reasonable if the amount would

ordinarily be paid for like activities by like enterprises under like

circumstances. Amounts supposedly paid for research that are not

reasonable under the circumstances may be characterized as disguised

dividends, gifts, loans, or similar payments. The reasonableness

requirement of this paragraph (a)(6) does not apply to the

reasonableness of the type or nature of the activities themselves.

(7) This paragraph (a) applies to taxable years beginning after

October 3, 1994.

* * * * *

Dated: September 9, 1994.

Margaret Milner Richardson,

Commissioner of Internal Revenue.

Approved: September 9, 1994.

Leslie Samuels,

Assistant Secretary of the Treasury.

[FR Doc. 94-24153 Filed 9-30-94; 8:45 am]

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